Tag: Robert Solow

Part II: The Neoclassical Response to the Classical Theories of Inequality and Growth

Mason Gaffney has shown how many individuals helped construct neoclassical economics, often with financial support from the robber barons and their successors. I will focus on two: in the United States, John Bates Clark (1847-1938), and in Europe, Vilfredo Pareto (1848 to 1923).

Recall from Part I that the classical economists divided society into three classes: Owners of land and other natural resources received unearned income or “rent” from their holdings—often derived from conquest or inheritance. Capitalists (who often overlapped with landowners) owned physical capital (like factories or ships) and received interest or profit from investing. Workers received wages. Also recall that the classical economists favored taxing “rent” by taxing land values; Henry George crusaded for this tax.

John Bates Clark of Columbia University, for whom is named the prestigious John Bates Clark Medal, transformed economics into an inequality-free abstraction.

Writing in the 1890’s, Clark merged land into physical capital, thus obliterating the classical understanding of land. In the new neoclassical world, capital (including land) originates solely from productive investment. There is no unearned “rent”, only legitimate “profit.” (Ironically, Marx merged rent into profit because he considered both illegitimate.)

Clark reduced economics to only two “factors of production”, capital and labor. In Clark’s model, “supply and demand” in a free market ensure that capital and labor each earns its “marginal product”, that is, the contribution of the final amount supplied. This outcome is supposedly both fair and efficient. Clark writes, “the share of wealth that falls to any producing agent tends, under natural law, to equal the amount that he creates. A man’s pay tends to equal the value of the product or fraction of a product that can be specifically imputed to him.” (Clark, 1898: 4) So much for any claim that laborers are exploited!

Clark also eliminated time, —giving us the familiar time-less, space-less, context-less world of Economics 1. But without time, there can be no history, and without history, no questioning the justice of property ownership, or the legitimacy of institutions.

Neoclassical economics in the United States followed Clark, to the extent that the future Clark Medal and Swedish Bank “Nobel” prize winner Robert Solow could joke in 1955 that “…if God had meant there to be more than two factors of production, He would have made it easier for us to draw three dimensional diagrams.” (Solow, 1955: 101)

Meanwhile, over in Europe, Italian nobleman Vilfredo Pareto made two key contributions to the emerging neoclassical paradigm. First, he estimated that 80% of the land in Italy belonged to 20% of the population, from which he concluded that inequality follows a natural law: the 80:20 rule, with which we shouldn’t tamper. More famously, he developed the policy rule known as “Pareto improvement.” Pareto improvement holds that we should undertake no policy changes unless they make at least one person better off and no one worse off. Sounds fair and reasonable, doesn’t it? By that logic we should have paid the slaveholders in full after the Civil War! By that logic once having cut taxes on the rich, we cannot raise them again! The status quo rules, no matter how cruel or illogical the route that got us there.

Under the new neoclassical regime, mathematical models proliferated like kudzu vines in the south, their very complexity keeping them safely obscure. Few are more famous (among economists) than Robert Solow’s 1956 simple two-factor growth model. Assuming a world of uniform depreciating physical capital (implicitly ignoring durable natural resources like land), and uniform quality labor, Solow’s model predicts that economies will grow towards a steady state where depreciation just equals new investment. And because the richer you are the slower you grow, poorer economies and poorer people within economies will catch up. Solow’s model is cute as a button!—but its extreme abstractness lies poles apart from Smith’s original common sense model explaining growth in terms of cooperation and specialization.

Almost sixty years later, Thomas Piketty has taken Solow’s model and added his own twist. In Solow’s model, the poor catch up to the rich. In Piketty’s model, the modern decline in growth does not affect investment. Consequently, now that return to capital investment exceeds the rate of growth, then inequality must inexorably increase. This model, he says, determines the fate of the twenty-first century.

Critics have torn into Piketty’s model—including some, like James Galbraith, who still give Piketty kudos for stirring up debate. In my view, Piketty’s and Solow’s models are both fundamentally flawed in that they rest on the same ahistorical, apolitical, two-factor neoclassical foundation. As the classical economists understood, inequality derives from power, ultimately the power of conquerors to extract tribute from the conquered. And as the Progressives, the New Dealers, and the civil rights activists have demonstrated, democratic societies can counter that power with well-designed tax and regulatory policies supported by an aroused public. We are not prisoners of a mathematical model.

This is the third of our book reviewer Steve Pressman’s live-blogging posts on Thomas Piketty’s Capital in the 21st Century. His first post appears here.

My first stab at examining the reviews of Piketty took cuts at those who failed to read the book but felt they had the right to express an opinion about it. Today I look at positive reviews of Capital in the Twenty-First Century.

In general, the book has garnered critical acclaim. Mostof the early reviews were glowing. Reviewers were virtually unanimous in praising the book for being so well written and well translated. They also wrote about Piketty’s careful collection of economic data, from numerous countries, going back in time for a century or more, and for his clear presentation of historical trends. Finally, reviewers admired Piketty’s breadth and erudition. Many noted, approvingly, references to Jane Austin and Balzac’s Père Goriot, something atypical for an economist. How could anyone not want to read Piketty’s new book after reading comments like this?

A few reviewers provided a bit more idiosyncratic reasons for liking Capitalism in the Twenty-First Century. Lynn Parramore, writing at Alternet, praises Piketty for giving “right-wingers in America the willies”. And Steven Erlanger, writing in the New York Times on April 19th, praises the book for daring to ask big questions and for questioning the conventional wisdom concerning income inequality.

Of the many positive reviews, three stand out as being the most informative and useful. These reviews (by Paul Krugman, by Branko Milanovic, and by Robert Solow) are worth reading– whether or not you take the plunge and read Piketty. All provide clear summaries of the book and highlight what makes it so important.

Krugman, as is his style, minces few words in his May 8th New York Review of Books article (Why We’re in a New Gilded Age). He contends that the book will “change both the way we think about society and the way we do economics” and then points out several ways that the book advances our knowledge of income inequality. First, and most important for Krugman, Piketty shows that the very wealthy (the top .1%) have for the most part not earned their income. They tend to be rentiers—they have inherited their wealth. Their income mainly comes from owning capital rather than working. Having a very high income is therefore not the result of great effort or smarts—unless, somehow, it took effort or smarts to be born to affluent parents.

This fact about inequality naturally leads to Piketty’s main policy solution—higher income taxes on the very wealthy and a wealth tax. If high incomes are not earned, if they are the result of luck or getting a large inheritance, then high tax rates on income are less objectionable because they don’t distort economic incentives very much. On the other hand, they will have many positive effects if they succeed in reducing inequality. And if wealth inequality has negative economic and social effects, a case exists for a wealth tax.

Milanovic has written a lengthy and brilliant review of Piketty that will appear in the June 2014 issue of the Journal of Economic Literature, one of the premier journals in economics. It is published by the American Economic Association, and it publishes literature surveys and long reviews of books that the editors regard as especially important. For those unable to wait until June, and for those who do not subscribe to the Journal of Economic Literature, an early draft of this review is available here.

Milanovic calls Capital in the Twenty-First Century “one of the watershed books in economic thinking”. He then goes on to explain why.

His review demonstrates both a careful reading of Capital and a detailed knowledge of Piketty’s previous work. It explains that the value added by Capital is a “general theory of capitalism”. In brief, Piketty shows that annual returns to capital income (which mainly go to the very wealthiest households) have been relatively constant at 4%-5% over long historical stretches and have exceeded the annual rate of economic growth, whose gains go to average households. The result must be greater inequality, as more income gains go to the wealthy than go to other families.

There are few notable exceptions to this trend—wars leading to the destruction of capital and high tax rates in order to finance the fighting, and periods of hyperinflation that destroy wealth. During the Golden Era, the post-war decades, high taxes on high incomes and wealth reduced income equality and led to a rising middle class.

But such brief historical epochs are aberrations according to Piketty; the dynamics of capitalism tend to return to long-term trends. Rising inequality is inevitable due to the math of returns to capital that exceed economic growth rates.

As a further benefit, Milanovic’s review compares Piketty and the views of other top economist who have recently written about broad historical trends in growth and inequality. While others see the past century “as the dawn of even better days to come” and history as leading to economic gains for average families, Piketty sees the advances made during post-war decades as temporary and unlikely to return. Piketty stands virtually alone in seeing capitalism an economic system that generates widening income inequality; as a result, most families can look forward to income stagnation as gains from economic growth go primarily to the filthy rich.

Solow has written a wonderful review of Piketty in The New Republic (Piketty Is Right) that was published on April 22nd. It focuses to a large extent on the data that Piketty has collected and the claim (based on this data) that inequality has an inexorable tendency to rise in capitalism. Solow praises Piketty for having gathered important economic data stretching back many centuries; however, he is highly critical of the claim that inequality must rise under capitalism. His main point is that Piketty has provided historical evidence about past trends but, as mutual funds all warn, there is no guarantee that past results will continue into the future. For this, a theory about returns to capital is necessary.

Following along the lines of his theoretical work on economic growth, which earned him a Nobel Prize, Solow claims that diminishing returns to capital should reduce the returns to rentiers over time and counter any tendency for inequality to rise under capitalism. In contrast to Piketty, Solow sees things returning naturally to a somewhat steady state, where the distribution of income between capital and labor remains relatively constant over time.

My next post will consider some other critiques of Piketty’s book and its bleak prognosis.